Wednesday, 31 December 2008

Valuing a start up

Assessing the value of a start up is one of the most difficult things to do. Investors and investment bankers may like to give the impression that there is a method to it but the truth is that valuating an early stage company is an imprecise science, that depends on a number of factors some of which have little to do with the intrinsic value of your company and more to do with the environment.

So what do VC’s look at while valuing a company. Most investors give you similar answers –

Size of potential market – Generally the larger the better

Quality of the management team - passionate, broad based management teams with complementary skills and domain expertise preferred

Business model – Who pays and for what? How much will they pay? How scalable is the model? Does head count need to scale proportionately with revenue?

Competitive landscape – it is good to be first mover or at least early mover, however if it involves the creation of a new category or market or a radically new consumer habit then it can be risky. It’s nice if customers are used to currently spending money for the same purpose and your offering solves the problem better and you propose to earn revenue from existing spend budgets. It’s also good if this is a proven business elsewhere in the world.

Stage of company – the earlier the company in its life cycle the more risky it is however an investment in an early stage company can yield massive upside to the investors if it goes on to succeed. In spite of the fact that we were probably overpriced in our first round of fund raising, our investors earned a return of slightly under thirty times over a seven year period.

Quality of offering – This a tricky one. How good is the offering? Will it get traction among customers?

Cost structures and potential margins – How large are the margins likely to be when the business scales up? Will margins increase with scale - does the business have operating leverage?

Market structures and market power - Is there likely to be excessive dependence on a few customers? Can the business build up massive dependency for its services among its customers? Will there be switching costs for customers? Does the business build defensible intellectual property? Will there be barriers to entry for competition in the future?

Basically all these are surrogates by which investors can get some sense of potential return and risk – a peek into the future.

Yet there are external factors which will finally influence whether or not a VC will invest in a particular company and if so at what valuation.

At Naukri, in April 2000, we raised our first round of venture funding at a valuation of around Rs. 44 crores - we had achieved sales revenue of Rs. 36 lakhs in the year gone by and. Sounds insane – well it happened. It was a bubble investment – dotcoms were flavor of the month, investors were competing to give us money (we had two offers on the table and we had spoken to only four investors), the Internet was expected to change the world and everyone was going to get very rich very fast. Six months later as it became apparent that the bottom had dropped out of the dotcom market the company would probably have been valued at around Rs. 2 crores even though revenue was going to more than double over the previous year.

Most investors will deny it but there is some kind of herd mentality among many investors. They compete with each other and they talk to each other. So if one investor makes a certain kind of investment that looks like a smart thing to have done it spurs others on to make investments in similar companies. When dotcoms were in fashion in the late nineties everyone wanted to invest in the internet sector. The ensuing competition resulted in a de facto auction and pushed valuations sky high. And when investors decided that they wouldn’t touch dotcoms with a barge pole, valuations were in the basement for a long long time.

Bubble investments followed by a situation where companies were left with no hope of a second round, subsequent tranches were held back, they were merged, promoters were sacked and replaced by professionals - many simply shut shop. All in all it there was a lot of pain for everyone. Yet the intrinsic worth of the companies had not changed much from the time they received their first round investment till the time they were forced to shut shop.

Irrational exuberance followed by irrational pessimism.

Just as beauty is in the eye of the beholder, valuation is in the eye of the investor.


Amar said...

Now that "irrational pessimism" (or near abouts) has set-in, what are your recommendations for startups looking to raise money at "reasonable" valuations?

Anonymous said...

Interesting observation Sanjeev and information. The same thing was seen some time ago in real estate.

I understood the bubble in real estate around a year ago, while reading a book called Invest The Happionaire Way - Yogesh Chabria.

What are your views on online real estate sites which deal in sales, lease, buy, etc.?

Thanks and Happy New Year!